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Tax research: Planning questions
The second installment in a series on tax research questions.
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“Good fortune is what happens when opportunity meets with planning.”
This article is the second in a series on tax research. The first introduced the three types of tax questions and discussed compliance questions. This article discusses planning questions.
Before starting any tax research effort, we first need to know when and why tax research becomes necessary. Whether and how to do tax research begins with identifying the type of question asked.
Each type leads to a different kind of research depending on the end goal. The questions posed by tax professionals tend to fall into one of three types: compliance, planning, and reporting.
This article focuses on the second and most desirable type, planning questions.
Planning questions, or how to optimally structure a transaction
Planning questions ask about the optimal treatment of a proposed transaction. These come up when a relatively savvy taxpayer considers her options or consults with a competent tax or financial advisor ahead of time. Usually, there is no correct answer; rather, the taxpayer has a set or range of options.
Those options usually involve a tradeoff, and the taxpayer must choose her preferred option. The advisor should take the following into consideration:
Current and (expected) future tax rates.
Current and future income and expenses.
Beneficiaries or transferees of property, investments, and other assets.
How to ask a good planning question
A good question about tax planning does three things. First, it clearly focuses on the specific, distinct alternatives under consideration, and those alternatives have clearly different financial and tax consequences:
“Should the taxpayer invest in a Roth IRA or a traditional IRA this year?”
“Should the business request payment now or defer payment collection until next year?”
These questions focus on current and expected future tax rates and cash flow needs. There is no right or wrong answer to either question.
Second, it provides the taxpayer’s preferences over relevant tradeoffs:
“The taxpayer wants to minimize her current tax liability in order to maximize funds available for investing in her business.”
“The business prefers to collect as much cash as quickly as it can to fund planned expansion.”
Third, a well-stated planning question includes reasonable projections of the expected costs and benefits over a set period of time:
“If she invests the current maximum contribution each year into her Roth IRA for the next 20 years, and tax rates remain constant, she will pay $X in total taxes on the amount invested and have $Y per year of tax-free retirement income. If she instead invests in a traditional IRA, she will avoid $Z in total taxes on the amount invested and pay $U per year of retirement in taxes, assuming she withdraws $V per year for $W years.”
“The expansion will take six months to become revenue-generating. The company expects it to pay for itself within two years. The company had better-than-expected profits this year, so the owners expect a higher-than-normal tax liability. If they expand this year, they expect to pay $X in taxes this year and $Y next year. If they wait, they expect to pay $Z this year, but $W next year.”
Note that planning questions can involve multiple scenarios, with ranges of possible outcomes. Projections further into the future should incorporate greater uncertainty but still have clear figures.
A note on uncertainty. Tax preparation usually deals with absolute figures: we often know, to a penny, the amount of wage income or mortgage interest paid, for example. Running tax projections requires thinking in terms of ranges and confidence intervals. Most importantly, you must effectively communicate that uncertainty to the taxpayer. Be clear in your inputs and analysis, and give the taxpayer your best possible advice. You can only guide the taxpayer toward her desired outcome; she must make the journey there.
Planning questions that all three parts—distinct alternatives, preferences over tradeoffs, and reasonable projections—make your analysis and recommendation(s) much easier and straightforward.
Which details matter for a good planning question?
The details you need to ask a good tax planning question will be much less concrete, and possibly even more difficult to gather, than for a compliance question. You have to assess not only facts but also the taxpayer’s goals, fears, and feelings.
Current financial situation Provide a snapshot of the current financial landscape. Assets, liabilities, income streams, and existing tax positions all influence the best course of action. A tax strategy that reduces upcoming cash flow may not be feasible if the taxpayer lacks reserves or savings. It can be easy to let the tax tail wag the financial dog, especially for taxpayers swept up by a newly discovered strategy. Keep the bigger picture in mind.
Financial goals and timing Understand the financial objectives behind the question. Is the taxpayer looking to minimize current-year tax liability, optimize lifetime tax liability, or achieve long-term financial stability? Knowing the end game and the time to get there helps tailor the question.
Risk tolerance and flexibility Include the level and types of risk the taxpayer is willing to take. Some tax planning strategies are more aggressive than others. The longer the time horizon, the greater the likelihood of changes in tax law and economic conditions. Indicate how set in stone the planning scenario is. The more flexible the taxpayer is, the more options you will have, but if there are non-negotiables, make them clear.
And as always, don’t be afraid to ask the taxpayer a follow-up question or two. You don’t want to waste time with too many details for a projection, but you also don’t want to include irrelevant scenarios.